Sunspots (economics)
Encyclopedia
In economics
, the term sunspots (or sometimes "a sunspot") usually refers to an extrinsic random variable
, that is, a random variable that does not directly affect economic fundamentals (such as endowments
, preferences, or technology
). Sunspots can also refer to the related concept of extrinsic uncertainty
, that is, economic uncertainty that does not come from variation in economic fundamentals. David Cass
and Karl Shell
also coined the term sunspots as a suggestive and less technical way of saying "extrinsic random variable".
s might influence the economy, even if they bear no relation to fundamentals, is controversial but has been widespread in many areas of economics. For example, in the words of Arthur C. Pigou,
'Sunspots' have been included in economic models
as a way of capturing these 'extrinsic' fluctuations, in fields like asset pricing, financial crises
,, business cycle
s, economic growth
, and monetary policy
. Experimental economics
researchers have demonstrated how sunspots could affect economic activity.
The name is a whimsical reference to 19th-century economist William Stanley Jevons
, who attempted to correlate business cycle patterns with sunspot
counts (on the actual sun
) on the grounds that they might cause variations in weather and thus agricultural output. Subsequent studies have found no evidence for the hypothesis that the sun influences the business cycle. On the other hand, sunny weather has a small but significant positive impact on stock returns, probably due to its impact on traders' moods.
where the market outcome or allocation of resources varies in a way unrelated to economic fundamentals. In other words, the outcome depends on an "extrinsic" random variable
, meaning a random influence that matters only because people think it matters. The sunspot equilibrium concept was defined by David Cass
and Karl Shell
.
, their use of the term sunspot (a term originally used in astronomy
) alludes to the earlier econometric work of William Stanley Jevons
, who explored the correlation between the degree of sunspot activity and the price of corn . In Jevons' work, uncertainty about sunspots could be considered intrinsic, for example, if sunspots have some demonstrable effect on agricultural productivity, or some other relevant variable. In modern economics, the term does not indicate any relationship with solar phenomena, and is instead used to describe random variables that have no impact on the preferences, allocations, or production technology of a general equilibrium
model. The modern theory suggests that such a nonfundamental variable might have an effect on equilibrium outcomes if it influences expectations.
Cass and Shell refer to Keynes
' "animal spirits", and to the notion of self-fulfilling prophecy
to illuminate their use of the term "extrinsic uncertainty". Formally however they define it as any variable that does not directly affect the fundamentals of the economy.
, which can result from various types of extrinsic uncertainty. The sunspot equilibrium framework supplies a basis for rational expectations
modeling of excess volatility (volatility resulting from sources other than randomness in the economic fundamentals). Proper sunspot equilibria can exist in a number of economic situations, including asymmetric information, externalities in consumption
or production
, imperfect competition
, incomplete markets, and restrictions on market participation.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, the term sunspots (or sometimes "a sunspot") usually refers to an extrinsic random variable
Random variable
In probability and statistics, a random variable or stochastic variable is, roughly speaking, a variable whose value results from a measurement on some type of random process. Formally, it is a function from a probability space, typically to the real numbers, which is measurable functionmeasurable...
, that is, a random variable that does not directly affect economic fundamentals (such as endowments
Budget constraint
A budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...
, preferences, or technology
Production function
In microeconomics and macroeconomics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs...
). Sunspots can also refer to the related concept of extrinsic uncertainty
Uncertainty
Uncertainty is a term used in subtly different ways in a number of fields, including physics, philosophy, statistics, economics, finance, insurance, psychology, sociology, engineering, and information science...
, that is, economic uncertainty that does not come from variation in economic fundamentals. David Cass
David Cass
David Cass was a professor of economics at the University of Pennsylvania, mostly known for his contributions to general equilibrium theory. His most famous work was on the Ramsey growth model, which is also known as the Ramsey-Cass-Koopmans model.-Biography:David Cass was born in 1937 in...
and Karl Shell
Karl Shell
Karl Shell is an American theoretical economist, specializing in macroeconomics and monetary economics.Shell received an A.B. in mathematics from Princeton University in 1960. He earned his Ph.D...
also coined the term sunspots as a suggestive and less technical way of saying "extrinsic random variable".
Use
The idea that arbitrary changes in expectationExpectation
In the case of uncertainty, expectation is what is considered the most likely to happen. An expectation, which is a belief that is centered on the future, may or may not be realistic. A less advantageous result gives rise to the emotion of disappointment. If something happens that is not at all...
s might influence the economy, even if they bear no relation to fundamentals, is controversial but has been widespread in many areas of economics. For example, in the words of Arthur C. Pigou,
- The varying expectations of business men... and nothing else, constitute the immediate cause and direct causes or antecedents of industrial fluctuations.
'Sunspots' have been included in economic models
Model (economics)
In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using...
as a way of capturing these 'extrinsic' fluctuations, in fields like asset pricing, financial crises
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
,, business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
s, economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
, and monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
. Experimental economics
Experimental economics
Experimental economics is the application of experimental methods to study economic questions. Data collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic experiments usually use cash to motivate subjects, in...
researchers have demonstrated how sunspots could affect economic activity.
The name is a whimsical reference to 19th-century economist William Stanley Jevons
William Stanley Jevons
William Stanley Jevons was a British economist and logician.Irving Fisher described his book The Theory of Political Economy as beginning the mathematical method in economics. It made the case that economics as a science concerned with quantities is necessarily mathematical...
, who attempted to correlate business cycle patterns with sunspot
Sunspot
Sunspots are temporary phenomena on the photosphere of the Sun that appear visibly as dark spots compared to surrounding regions. They are caused by intense magnetic activity, which inhibits convection by an effect comparable to the eddy current brake, forming areas of reduced surface temperature....
counts (on the actual sun
Sun
The Sun is the star at the center of the Solar System. It is almost perfectly spherical and consists of hot plasma interwoven with magnetic fields...
) on the grounds that they might cause variations in weather and thus agricultural output. Subsequent studies have found no evidence for the hypothesis that the sun influences the business cycle. On the other hand, sunny weather has a small but significant positive impact on stock returns, probably due to its impact on traders' moods.
Sunspot equilibrium
In economics, a sunspot equilibrium is an economic equilibriumEconomic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...
where the market outcome or allocation of resources varies in a way unrelated to economic fundamentals. In other words, the outcome depends on an "extrinsic" random variable
Random variable
In probability and statistics, a random variable or stochastic variable is, roughly speaking, a variable whose value results from a measurement on some type of random process. Formally, it is a function from a probability space, typically to the real numbers, which is measurable functionmeasurable...
, meaning a random influence that matters only because people think it matters. The sunspot equilibrium concept was defined by David Cass
David Cass
David Cass was a professor of economics at the University of Pennsylvania, mostly known for his contributions to general equilibrium theory. His most famous work was on the Ramsey growth model, which is also known as the Ramsey-Cass-Koopmans model.-Biography:David Cass was born in 1937 in...
and Karl Shell
Karl Shell
Karl Shell is an American theoretical economist, specializing in macroeconomics and monetary economics.Shell received an A.B. in mathematics from Princeton University in 1960. He earned his Ph.D...
.
Origin of terminology
While Cass and Shell's 1983 paper defined the term sunspot in the context of general equilibriumGeneral equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
, their use of the term sunspot (a term originally used in astronomy
Sunspot
Sunspots are temporary phenomena on the photosphere of the Sun that appear visibly as dark spots compared to surrounding regions. They are caused by intense magnetic activity, which inhibits convection by an effect comparable to the eddy current brake, forming areas of reduced surface temperature....
) alludes to the earlier econometric work of William Stanley Jevons
William Stanley Jevons
William Stanley Jevons was a British economist and logician.Irving Fisher described his book The Theory of Political Economy as beginning the mathematical method in economics. It made the case that economics as a science concerned with quantities is necessarily mathematical...
, who explored the correlation between the degree of sunspot activity and the price of corn . In Jevons' work, uncertainty about sunspots could be considered intrinsic, for example, if sunspots have some demonstrable effect on agricultural productivity, or some other relevant variable. In modern economics, the term does not indicate any relationship with solar phenomena, and is instead used to describe random variables that have no impact on the preferences, allocations, or production technology of a general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
model. The modern theory suggests that such a nonfundamental variable might have an effect on equilibrium outcomes if it influences expectations.
Cass and Shell refer to Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
' "animal spirits", and to the notion of self-fulfilling prophecy
Self-fulfilling prophecy
A self-fulfilling prophecy is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior. Although examples of such prophecies can be found in literature as far back as ancient Greece and...
to illuminate their use of the term "extrinsic uncertainty". Formally however they define it as any variable that does not directly affect the fundamentals of the economy.
Occurrence of equilibria
Much work on sunspot equilibria aims to prove the possible existence of equilibria differing from a given model's competitive equilibriaCompetitive equilibrium
Competitive market equilibrium is the traditional concept of economic equilibrium, appropriate for the analysis of commodity markets with flexible prices and many traders, and serving as the benchmark of efficiency in economic analysis...
, which can result from various types of extrinsic uncertainty. The sunspot equilibrium framework supplies a basis for rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
modeling of excess volatility (volatility resulting from sources other than randomness in the economic fundamentals). Proper sunspot equilibria can exist in a number of economic situations, including asymmetric information, externalities in consumption
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
or production
Manufacturing
Manufacturing is the use of machines, tools and labor to produce goods for use or sale. The term may refer to a range of human activity, from handicraft to high tech, but is most commonly applied to industrial production, in which raw materials are transformed into finished goods on a large scale...
, imperfect competition
Imperfect competition
In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...
, incomplete markets, and restrictions on market participation.